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Deep Dive Workshop: High Performance 401K and Pension Plans

4/25/2008

by Kimberly A. Lange, PricewaterhouseCoopers

On March 27th, Dr. Scott Weisbenner helped U of I alumni dive right into knowledge about participant choices in pension plans and how these are affected by the mix of plan options and plan restrictions. Weisbenner, assistant professor in UIUC's Department of Finance, was the speaker for the College of Business's Deep Dive Workshop, part of the Roundtable series sponsored by PricewaterhouseCoopers. Weisbenner presented a wealth of information based on his own and others' research and experience.

Weisbenner began by explaining the different types of pension plans. There are two main categories: defined benefit (DB) and defined contribution (DC). Defined benefit is formula-based (tied to salary and years of service), and it is the employer's responsibility to fund the pension. Defined contribution is account-based; the employee and/or employer make contributions, and the final balance depends on the account performance. DC plans require the employee to make contributions and sound investment choices. Today the most popular type of DC plan is the 401-k, which is named after an IRS code. Weisbenner predicts that in the next few decades, these will become as important a source of retirement income as Social Security.

With the growth of 401-k's has come a growth in mutual funds, mainly equity funds, which have quadrupled in the past 10-15 years. Equity funds make up about 60 percent of all mutual funds and also 60 percent of 401-k options.

The standard view of the mix of options offered to employees in a 401k is that more options are either good or unnecessary, but not bad. The behavioral view, which Weisbenner himself subscribes to, is that having more options to choose from can be potentially bad for the employee. Evidence shows that participation is actually lower in 401k plans with more choices than in those with fewer options of where to invest. It's possible that the prospect of having to choose from so many options makes people reticent from making a decision to participate at all.

These options can also impact how the people who do participate in a 401k invest their money once in it. Although employers do not offer any advice to employees as to how they should divide up their contributions, employees may read into a greater offering of a certain type of fund as the employer's recommendation to invest more in that particular type.

Restrictions also influence the behavior of plan participants. If a company restricts matching to stock, the participant will put more in stock, even though it would actually be better for him/her to more fully diversify the portfolio. The employee has wrongfully viewed this as an endorsement of stock. A similar effect is seen when employers place a ceiling on company stock. Here participants lower their investments in both company stock and all equities. Weisbenner adds that it's probably not a good idea to invest in our own company's stock, as our familiarity with the company may cause us to underestimate its risk.

Although in the majority of companies it is still up to the employee to initially enroll in a 401k plan, more and more employers are making enrollment the default, requiring employees to opt out rather than in. Does the type of default have an effect on behavior? Absolutely, says Weisbenner. When the default is to be enrolled in a 401k plan, 90 percent of employees stay in it. However, no matter how they get enrolled in a plan, once in it, participants then too often demonstrate another behavioral bias: inertia. According to Weissbenner, "Inertia is the number two force in finance. 50 percent of participants make no changes to their plan after their initial choices." Another behavioral bias pension plan investors are subject to is representativeness, which occurs when we put too much weight on recent events when trying to predict the future and make choices regarding our plan.

The bottom line is that the design of a pension plan really does matter. Weisbenner states, "Individuals are clearly influenced by details of the pension plan in ways that are not explained by standard models that assume 'rational' behavior." By keeping these biases in mind, we can hopefully overcome them to make the soundest financial choices for ourselves and our families.